Chapter 23: Aggregate Supply and Demand, the Growth Diamond, and Financial Shocks
Another way to consider economic activity returns to the basics of supply and demand, but at the greatest level of abstraction: the total demand for all goods and services and the total supplied in the context of a given market. Ultimately, that is the foundation of economics and the concern with money is secondary: money is merely a means of exchange, and any savings/investment activity merely delays spending money to obtain goods and services because the money set aside will inevitably be spent.
In this sense, phenomena such as inflation and interest merely move money from one set of hands to another. The interest paid by a borrower is received by a lender, who then spends that money on goods and services in the market. The inflation on consumer goods means that customers pay more to suppliers, but suppliers then have the additional amount to spend on the goods and services needed by their own operations, or given to their investors who again spend the money on the market. When all buyers and sellers are aggregated, it doesn't matter who spends the money - the same amount is spent.
It is a bit more difficult to consider the aggregate supply because suppliers cannot be as fluid as their behavior. A buyer with cash in hand can purchase one thing or another or nothing at all, and the decision is made in minutes. But to supply goods to market requires production facilities to be created, materials purchased, laborers directed, and finished goods transported long in advance of their being purchased by buyers. The supply of goods is not as elastic as the demand for them.
In the long run, suppliers will be guided to produce the items that are wanted by consumers, in the quantities desired by consumers, and at a price they are willing to pay (provided it covers the cost of production so that the suppliers' operations are sustainable). But in the short run, consumers decide among the options available to them in the market, provided by the past decisions of suppliers, which in turn were based on the expectations of what would be demanded.
There is also a delay in the supply chain as changes ripple through it. An increase in the price of fertilizer affects the cost to produce the next crop of corn, which raises the cost to produce the next season's herd of cows, which raises the cost of the next season's supply of leather, which raises the cost of the next season's supply of shoes. In general, the merchants who sell final goods have the greatest ability to raise their prices at their own discretion to adjust to demand, but it is the producers of raw materials that have the greatest power to raise them for the entire market. There's also a brief mention of long-term contracts that are commonly used in business transactions that may fix the price paid for some component or material for a long period of time.
Equilibrium Analysis
As in most instances, the analysis of an entire economy plots the supply and demand curve and seeks the magical and mythical point of equilibrium where the exactly right quantity and price of goods are produced to meet the precise amount of demand that exists for them. The notion of equilibrium becomes even less meaningful in the aggregate: and undersupply of one good balances out the oversupply of another, giving the appearance of perfection where in reality there is too much of an unwanted good and too little of a needed one - or in essence, that people are making the wrong things.
And similarly, it is believed by economists that the invisible hands of the economy will cause things to work out in the long run: that consumers will use their dollars to attract suppliers to making the things that society wants. Unfortunately, it is believed by government that this will not occur naturally, and that they are imbued with the power to help with a sweep of the pen and a rattle of the saber.
In an attempt to exercise power in a moderate way, political economists seek to apply legislative measures to ameliorate short-term aberrations and leave the long-run to take care of itself in spite of their interference. Taxes and incentives are used to discourage and encourage suppliers in the making of goods that regulators believe the people want, and at prices they believe that people can afford, meanwhile keeping wages at a high level and prices at a low level. But by far, the majority of regulatory activity consists of mitigating the damage done by the last round of regulatory activity.
The Growth Diamond
In recent years, economists have been focused on the supply side of economic growth. Demand itself is difficult to influence because it reflects the individual desires of millions/billions of customers to consume things, and it is assumed that people will happily consume whatever is provided. Controlling producers is much easier, as there are fewer of them and they are easier to threaten.
In terms of supply, the most critical function of an economic system is in connecting investors with entrepreneurs - which is to give those who wish to produce the means by which they can do so. In societies where these two factions are disconnected, those who need capital are disconnected from those who have it to lend, hence production does not take place.
There is also the matter of getting capital to the areas in which it is most needed, which is also a social benefit: consumers are willing to offer the greatest profit to the producers of the goods they most desire, and investors are not maximizing their profits by investing in operations that provide less-wanted goods and services to the market.
The "growth diamond" is an economic model that suggests four groups are critical to economic development:
- The government, which must protect its citizens and create peaceful conditions in which life, liberty, and property is secure
- A financial system that facilitates connections between investors and entrepreneurs
- The capitalists themselves, who provide the financial means to produce
- Management, who oversee the establishment and operation of production facilities
This model can be applied to almost every market, and it is generally found that the poorest countries are disadvantaged because of problems with these four basic groups: they have a government that kills and robs its own people, its financial system is not efficient (and may even be obstructive) in getting capital to producers, it may lack people with the capital to invest, or it may lack people who can make effective use of capital in their operations. In any case, the growth diamond gives economists more specific direction in improving the economy of a country where no-one can seem to tell what is broken.
It's also mentioned that economies have inertia - they tend to keep going in the direction they are going, and become stronger as they gather strength. The capital that creates productive facilities produces both goods for the market and income for the workers (to buy goods), which returns to the investors as profit, which they reinvest to create even more productive facilities, etc. Ultimately, the theory is if the broken bases of an economy can be repaired, it can enter into this virtuous and self-sustaining cycle.
Five Financial Shocks
The author defines five kinds of financial shock that "can have extremely negative consequences for economic growth" and "a strong propensity to initiate financial crises."
- Uncertainty - When investors are uncertain about future returns (as a result of inflation, interest, or general instability), then tend to withhold or even withdraw capital from the market
- Inflation/Interest - When interest rises, investors require higher returns and less business projects can deliver a sufficient rate of return to investors. Capitalists who are risk-tolerant are eager to lend, but borrowers are more likely to delay spending (and borrowing to spend).
- Government Fiscal Problems - When governments have financial issues, the taxpayers will eventually be saddled with the bill, creating uncertainty. In severe cases, the potential for government to default on loans or debase the currency sends capital abroad.
- Asset depreciation - The depreciation of assets (real estate value, for example) on a firm's balance sheet reduces its value to investors and reduces the equity on which it borrows. The firm is seen as high-risk and, in a self-fulfilling prophecy, must engage in high-risk operations to earn enough to pay lenders who will increase their demands.
- Banking problems - Banks are critical players in the circulation of capital, and anything that harms their performance becomes obstructive. Even before depositors panic, the availability of capital to industry is impaired, which again becomes self-sustaining as companies cannot borrow to earn profits to repay their debt.
Whereas the availability and circulation of capital is a virtuous cycle that provides more for everyone, a financial shock can kick off a vicious cycle in which less capital leads to less productivity which produces less capital. Unless regulators step in, an entire economy can quickly spiral downward.
But on the other hand, any activity taken by regulators is detrimental to the economy. There is no "free money" and any relief effort relies upon borrowing from future tax revenues or debasing the currency (and often both at once). The damage is not prevented, merely spread out over a longer period of time so that the economy can absorb it gradually.